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Buying a home for the first time can be both exciting and overwhelming. It's probably the largest purchase of your lifetime, and there's quite a lot to learn along the way. Each step of the process — from obtaining financing, to finding the right place, to making an offer, and closing the deal — is unfamiliar.
One thing that might be new to you is the concept of an escrow account. If you're taking out a mortgage, your lender will probably require you to have one to make sure you have enough money to cover the related expenses, including homeowners insurance.
Your real estate agent will usually set up an escrow account with your lender for you at closing. It's a separate bank account that consolidates your mortgage, property taxes, and insurance payments, including your homeowners insurance premiums. An escrow account will roll your payments into one account, so you don't have to worry about paying various bills each month. It also guarantees that you'll have enough money to cover lump sum payments on your homeowners insurance and property taxes when they come due.
Most lenders will require an escrow account. For instance, if you have a Federal Housing Administration (FHA) or United States Department of Agriculture (USDA) mortgage, you must set up an escrow account. However, you'll only need an escrow account for a conventional mortgage if you make less than a 20% down payment. As for VA mortgages, many VA lenders require them, but not all.
The amount you'll pay on your escrow account each month will vary based on the cumulative annual expense of your mortgage, property taxes, and insurance premiums. You calculate your monthly escrow payments by adding up your expenses and dividing the sum by 12. However, many lenders may require an escrow cushion, a surplus amount above your mortgage payments, to ensure you have enough funds. The cushion, however, cannot exceed two monthly escrow payments, according to the Consumer Financial Protection Bureau (CFPB).
While a homeowners insurance escrow account can be beneficial, it also comes with several drawbacks. If you have the option to use one or not, it is essential to consider whether a homeowners insurance escrow account is right for you, as it can be challenging to get rid of if you change your mind, says Dan Belcher, CEO of Mortgage Relief.
The benefits of an escrow account come down to whether you'd like to be more hands-off when it comes to your monthly payments or if you value agency over your account.
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There are instances where you can opt out of having an escrow account with your lender. Be aware that you are responsible for paying your expenses on time, often in a lump sum amount instead of monthly installments.
"The advantage of using an escrow account to pay your homeowner's insurance is knowing that you have a piece of mind that payments are made," says Maria Townsend, a licensed insurance broker in North Carolina and CEO of Insured Stash, an insurance educational platform. "However, consumers can also pay annually without escrow, if they have a substantial amount for their down payment on their property."
Here's how to set up an escrow account on your own:
Verifying your total annual bill will determine how much you'll need to deposit in your escrow account monthly. Insurance companies may ask you to pay quarterly or every six months instead of annually. Contact yours to determine the exact amount you have to pay and when your payments are due. Similarly, you want to contact your local tax collector for payment dates and amounts. You may be required to pay quarterly, every six months, or annually.
Add your annual insurance premiums and property taxes and divide the sum by 12. This amount is how much you'll be paying into the escrow account each month. As property taxes and insurance rates may fluctuate, you may want to include a cushion to prevent shortfall. This way, you can avoid late fees and penalties.
Contact private banks and mortgage lenders to inquire about escrow account options. Have your details and information of any other parties applying for the account on hand. Alternatively, you can put your monthly property taxes and insurance payments in a high-yield savings account to earn higher interest on your money.
Like an escrow account managed by your lender, it is a good idea to automate your deposits to ensure you have sufficient funds in your account. Similarly, you should automate your withdrawals from your account to your insurance company and tax department, so you don't default on your payments and can avoid late fees. Note that if you set up an escrow account with a bank, your bank will manage payments for you but may charge a fee for that service.
Be sure to monitor your account to reflect any changes throughout the year. Property taxes and insurance premiums fluctuate, and you want to ensure you have a sufficient amount to pay your bill.
Although not legally required, keeping your homeowners insurance policy after you've paid off your mortgage is a good idea, says Townsend. Homeowners insurance protects your dwelling and personal property from damage. It also can protect you from liability if someone is injured on your property.
The last thing you want is to undergo an unexpected, home-related loss and be unable to pay for replacements. Insurance is there to help you prepare for the worst and alleviate financial hardship from a home-related loss, especially if you live in a high-risk area.
If you want to switch to a different homeowners insurance provider when making payments through an escrow account, it's important to update your mortgage lender with the new information.
After comparing quotes and making the switch, you'll need to submit the lender's mortgage clause information to your new insurance company, and their insurance advisor will send the proof of insurance, says Townsend.
It usually doesn't cost anything to change your homeowners insurance, but the insurance company may have a cancellation fee if you decide to suspend your policy. Also, take note of any shortages or overages on your monthly payments during the time of the switch as your monthly mortgage payments may change.
